To Hedge or Not To Hedge: Dry Bulk vs Tanker FFAs
The shipping industry’s core purpose is to facilitate global trade of commodities. While freight rates are a revenue item for shipowners, they are an expense item for commodity movers.
Commodity movers must determine how much capital to invest into managing their shipping costs. The central question of this calculation: how important are freight rates in the profitability of their core business (buying a commodity in one country and selling it in another)?
Freight can either be a rounding error, and a "necessary evil”, or it can be a very material part of the profitability of buying and selling commodities around the world.
Let’s examine the importance of freight rates for tankers–specifically crude oil and very large crude carriers (VLCCs).
Commodity: Crude Oil
Vessel capacity: 2 million barrels
Commodity price: $60 per barrel
Cargo value: $120 million
The freight cost on the benchmark VLCC route from the Middle East Gulf to China is approximately $3.5 million today according to the Baltic Exchange. The cost of the freight ($3.5 million) is less than 3% of the value of the cargo ($120 million). So, with tankers, freight rates are not central to the profitability of commodity movers’ core business, therefore they are less likely to invest much into managing their shipping costs.
Now, let’s look at the significance of freight rates for dry bulk vessels–specifically iron ore and Capesize bulk carriers.
Commodity: Iron Ore
Vessel capacity: 170,000 metric tons
Commodity price: $105 per metric ton
Cargo Value: $18 million
The freight cost on the benchmark Brazil to China route is approximately $3.3 million today. So, the cost of the freight is a little less than 20% of the value of the cargo ($18 million). So in the case of dry bulk vessels, freight rates are central to the profitability of commodity movers’ core business, therefore they are likely to invest capital into managing their shipping costs.
Commodity movers use derivative contracts to “hedge” their exposure to variability in costs that impact their primary value proposition–all sorts of companies do this. From airlines using derivatives to manage their jet fuel budgets, to candy bar producers using derivatives to control the cost of the cocoa they need to buy.
For commodity movers, the derivatives are forward freight agreements (FFAs), and these FFAs matter a lot more with dry bulk carriers than with tankers. The daily liquidity of dry bulk and tankers’ respective FFA markets backs up this point—for dry bulk FFAs, it’s up to $200 million; for tanker FFAs, it’s close to $20 million.
